Desperate accountant head in hands surrounded by bills on paper tape, 1950s style office

This article appears in the May 2020 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

In the present world of extreme stock volatility, short-dated government debt has been the ring seemingly everyone wants to grasp because investment-grade corporate bonds have traded at exceptional discounts. But there are promising plans to rescue overleveraged companies. Sound corporate debt management seems to get little respect. It’s a world turned upside down.

Corporate debt became a pariah during the deepest dips of the present crisis. iShares Canadian Corporate Bond Index ETF (ticker: XCB) fell by an extraordinary 23% within 11 trading days before ending its rout on March 24. The rout was the first move in what is likely to be high volatility in prices and yields in the usually tranquil market for corporate debt. Short-dated bonds in iShares Core Canadian Short Term Bond Index ETF turned in a 2.89% all-in return year-to-date as of April 15. As of the same day, XCB showed a 1.71% return, lagging the shorts.

The irony of solid, investment-grade corporate debt languishing while short-dated government notes thrive needs an explanation. The reason appears to lie in the rush to safety at any cost, which has pushed up prices of government debt and left the broader bond market as the orphan.

This explanation needs further explanation. During the high-flying days of the market recovery that began in March 2009 and continued — with frequent interest rate reductions by central banks — until February, companies exploited the opportunity to buy back shares with cheap debt.

Today, fear rules. Companies with the cash to pay down senior investment-grade debt are doing so lest the rating agencies smite them. (Biblical language is appropriate: it is the market’s revenge for greed and the time of comeuppance for companies that stayed alive by borrowing cheap with ever lower interest rates.)

The big picture is that dropping interest rates keep troubled companies alive. New York-based Moody’s Corp. projects that speculative-grade (a.k.a. junk) bond defaults will decline to 3.5% of outstanding bonds, weighted by value, from 4.2% in December 2019. This is the cost-of-carry number, but go behind the data and a grim picture emerges. Debt considered by New York-based S&P Global Market Intelligence to be the weakest links among junk bonds rose to 10.9% of outstanding debt in the category at the end of 2019, up from 6.8% a year earlier.

The pigs went to the trough to fatten on cheap debt. Now that earnings are down, those companies have to unload debt — and the future looks brutal. The only way they can sell debt on leveraged balance sheets is for cheap. And that debt is what junk-bond buyers have been picking up.

Junk-bond prices herald what may happen to equities. If companies’ debt slides into Sub-BBB Land, then as much as US$1 trillion of outstanding bonds could go junky. Recall the 2009 insolvency of General Motors. This year, Ford Motor Co.’s rating is on the brink of tumbling into Junkland, with its Fitch Ratings Inc. rating of BBB-minus. At BB, Ford’s rating will have arrived in the bond sewer.

Says Chris Kresic, head of fixed-income and asset allocation with Jarislowsky Fraser Ltd. in Toronto: “2008 was an endogenous crisis. This time, central banks are providing direct support for their economies [by] funding expenditures directly with unlimited funding.”

The U.S. Federal Reserve Board has been working hard to keep debt markets functioning. It announced on April 9 that it would buy up to US$2.3 trillion of a combination of iffy loans from banks and debt down to BB-minus on the open market. This dip into junk has a rationale — that much of it was recently investment-grade.

The prospect of an ocean of Fed money gushing into the junk bond market has loosened a flood on a biblical scale of freshly minted junk with coupons up to 14%. This calibre of junk is distressed from the start. The Fed will pay Tiffany’s prices for pawnshop goods. The Fed is sure to take losses when the time comes time to sell.

The consequence of adding junk to the central bank’s balance sheet is that the Fed itself could wind up needing rescue. After all, the Fed, which is considered to be a commercial bank, may not pass regulatory stress tests. The issue comes down to what bonds are worth.

Geof Marshall, senior vice president, portfolio management, and head of fixed-income with CI Investments Inc. in Toronto, manages a $70-billion portfolio of bonds. In his view, the trouble in corporate bonds reflects liquidity where nobody wants to bid except at a giveaway price as much as it reflects risk.

High-yield markets are being resuscitated, but there’s demand for security — or hefty pay for lack of it. The bet now is on the rescue. That’s why safe shorts and junk zombies are market leaders.